Activity-cycle momentum remains intact

Global context:

The robust activity-cycle trend – led by the Eurozone and the US – remained intact over the month, with the expansion stage still well-anchored in both regions. In the US, economic momentum remained strong, thanks to very positive ISMs (Manufacturing and Services) and labour market prints. In the Eurozone, momentum continues to build, as the economic sentiment indicator – supported by better prints in an activity cycle that continues to reach new highs – has remained very positive. Growth is pointing upwards in most countries in the G10, as activity cycles are in expansionary mode. However, the decline in UK activity (two consecutive months now) is noteworthy. With housing prices on the decline, we expect this weakness to continue.

The inflation cycle extended its gradual strengthening across the board, with the US and Eurozone once again leading the way, while Japan and the UK presented a mixed bag. In the US, the inflation trend has improved significantly over the last 6 months, with all indicators up (producers, wages, and expectations). In the Eurozone, inflation dynamics are expected to have improved by mid-year through several sub-indicators (in particular, wages). We are already seeing an improvement in the expectations component, which is now contributing positively. In the UK, the inflation cycle appears to have reached a peak, with a constantly decreasing housing component. All in all, the inflation picture is exhibiting an upward trend across developed markets, with most countries in the inflation or reflation phase of the cycle.

Europe seems to be the only region resisting on the debt-cycle front, while the slowdown in US credit creation continues, weakened by low loan demand due to US policy uncertainties, higher leverage and bond supply. Weakness is spreading amongst G4 countries, as Japan and the UK have joined in the decline, though at a slower pace. This is an important factor to be taken into account, as the debt cycle is a leading indicator of the activity cycle. Hence while we do not foresee any immediate declines or necessary cause for alarm at this juncture, this indicator does call for a cautious stance.

Regarding the monetary cycle, the US outlook remains positive, with a hike operated in March and a further three scheduled for the remainder of 2018. We aim to monitor communications from new chairman Powell and revisions from the Fed’s economic projections (SEP). In Europe, the ECB continues to carefully communicate and to prepare markets for the end of the QE programme. The BOE, on the other hand, faces concerns, as a tightening policy implemented during declining activity and a fall in housing prices could put additional pressure on the Bank, forcing it to adopt a more dovish stance.

The month was especially marked by strong declarations from the US administration, as President Trump delivered upon his campaign promises by initiating tariffs on steel and aluminium imports. Furthermore, the president singled out China as the target of his “trade tantrum”, by specifically increasing tariffs on roughly $50 billion of Chinese imports. Retaliation was swift, as the Chinese government reciprocated with measures of their own. While the real impact of the decision remains minor at the moment, the additional threats made by both sides have led to a sell-off in equity markets and short periods of risk-off in FI markets.

Global rates strategy

Tactical Long US vs. Strategic Core Eurozone Short

In spite of the improving macroeconomic outlook and better inflation numbers in the US that had led us to previously hold a short position on Treasuries, we remain wary of current market movements. Indeed, the sporadic “risk-off” episodes are likely to lead to increased appetite for safe havens. As President Trump continues to drop bombshells, in terms of trade protectionist policies, we believe that Treasuries could tactically yield a positive performance. Furthermore, the heavy market positioning on US Treasuries (underweight/shorts), in spite of the recent decline in yields, leaves investors exposed to sharp corrections. Hence, while, over the long run, we continue to be cautious about the US curve, on a tactical basis we hold a long position to US Treasuries. We are particularly focussed on the long end, which is likely to be less affected by the repricing of the market expectations of the Federal Reserve’s actions. We remain flexible and moderate on this position. In Europe, the continuous rise in the activity cycle and the tapering of QE by the ECB made us decide to continue to hold a short position on the core EUR curve. In spite of the recent strong performance of the German Bund, improving activity and better inflation data continue to emanate from the Eurozone, reinforcing our conviction to hold an underweight duration on core EU rates.

The non-core European bond markets are supported by the ECB, and flow dynamics are also positive. Peripheral sovereigns also benefited from the reallocation from credit in March while substantial reinvestments should be carried out by the ECB in April. Furthermore, valuations remain attractive across the non-core government bond markets. Despite the reduction in purchases by half from January 2018, purchases and reinvestments remain sizeable in an open-ended programme. In this context, we tactically increased our exposure to Spanish sovereign bonds, as these benefit from the reduced political risk, strong flows and improved economic dynamics. Our already-long exposure to Portuguese bonds has been maintained. Regarding the Italian elections, the main short-term event risk is currently related to the formation of a government, as no clear majority stands out, while populist parties (M5S and LN) gained more than expected. We believe that very little of this political risk has been priced in, and we hence maintain a cautious stance on Italy.

Exposure to US, Canadian Break-evens, adding Euro

US break-evens, which appear to be particularly attractive, are supported by the positive carry profile. The inflation cycle remains strong, despite somewhat disappointing data more recently (average hourly earnings). Valuations on Canadian linkers are also attractive, but we are now more cautious on Japanese linkers. In the UK, on the other hand, valuations remain expensive. In this context, and in spite of some recent less favourable inflation data, we hold a favourable view on break-evens in the US and Canada. Furthermore, we have turned slightly positive on Eurozone break-evens. Valuations are attractive, as the carry has turned positive. With rising inflation expectations, we have initiated long positions on EU break-evens.